Oil Prices Rise on Renewed Tensions in Middle East

December 29, 2008

Over the weekend, violence erupted between Israel and Palestinian militants in the Gaza Strip. So far, the death toll has reached 300, and there's no telling when the hostilities will cease.

As a result of the violence, oil prices surged Monday to over $40 a barrel—that's an 8% increase that simultaneously lifted energy and other commodities stocks in Europe and Asia. Investors fear that the Israeli attacks on Hamas in the Gaza Strip could disrupt crude supplies coming out of the Middle East in general.

The market has always been sensitive to conflict in that region, especially since the Middle East accounts for a third of global crude oil production.

Investors remain skeptical about the reliability of Mid-East crude oil supplies and with good reason. Earlier this month, OPEC agreed to remove an additional 2.2 million barrels of crude from daily production, effective January 1. Already, the United Arab Emirates is cutting February crude shipments by as much as 15%, according to Asian refiners. This makes the UAE the first OPEC producer to formally reduce February exports since the agreed upon production cut. The UAE is the third-largest oil producer in OPEC and its steep cut in crude oil output raised the prospect that OPEC would more closely comply with the December cut than it did to an earlier reduction of 1.5 million barrels a day agreed to in October.

Although the backdrop to the oil market is still characterized by slumping demand, other signs are emerging that oil prices are trying to find a bottom. For one, the U.S. Department of Energy, the International Energy Agency and the OPEC Secretariat all reduced their forecasts for oil demand growth in 2009. To counter the soft demand, OPEC will have no choice but to cut production further.

Secondly, the Energy Department reported last week that U.S. crude oil supplies declined 3.1 million barrels to 318.2 million for the week ended December 19. This caught analysts off guard since most were expecting a 1.5 million barrel increase in crude oil inventories.

The bottom line is crude oil prices won't stay low forever. As the economy heals, stability will return to the oil market and prices will resume their upward trend.